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Calculate Price and Dividend Ratios

Calculate price and dividend ratios to help you
figure out the current value of a stock.

Of all the ratios used in stock valuation, probably none is as
popular as the price/earnings ratio (sometimes
known as the P/E ratio or
multiple). The P/E ratio compares the current
price of a stock to the amount of money the company has earned. One
interpretation of the P/E ratio is the measure of how much investors
are willing to pay for each dollar of earnings the company generates.
Not only does it help you judge whether a stock’s
price is reasonable, it can indicate the confidence investors have in
a company’s future. The more investors are willing
to pay for a dollar of earnings, the higher their expectations for
future performance. If investors won’t pay much for
a dollar of earnings, they have little confidence in the company. The
P/E ratio is calculated with the formula in Example 4-8.

Example 4-8. Formula for a basic P/E ratio

P/E Ratio = $ Current Share Price / $ Current Annual EPS

You can use a P/E ratio in your stock analysis in a couple of ways.
First, you can compare the P/E ratios of two or more similar stocks
to determine which stock is a better value. You can also use the P/E
ratio as a proxy for a stock’s value. You
can’t directly compare the prices of stocks. Is a
$32 share of Intel stock really more expensive than a $27 share of
Microsoft? However, if you compare the P/E ratios of both companies,
you can see whether you’d have to pay a premium for
one or the other. For example, at $32 a share,
Intel’s P/E ratio is about 45. Microsoft at $27
sports a P/E ratio of 29. Both stocks carry high P/E ratios, but in
this example, Intel is quite a bit more expensive than Microsoft.

P/E ratios can vary greatly by industry (banks often trade at lower
P/E ratios than other industries, for instance), size of company (a
larger company might have a lower P/E ratio than a similar but
smaller business because it’s easier for the smaller
company to produce faster growth in the future), and reputation
(popular, stable companies often command a premium P/E ratio in the
marketplace).

You can also use the P/E ratio of a stock to determine if the current
price of a company is reasonable based on its history. By comparing
the current P/E ratio to the stock’s average,
average high, and average low P/E ratios of the past few years as
demonstrated in Figure 4-4, you can see whether the
stock is a bargain or overpriced. If the stock has sold usually at a
P/E ratio of 35 in the past and now sells for a multiple of 28, it
might be undervalued or the lower P/E ratio could be a red flag. P/E
ratios drop for two reasons: either company earnings are growing
faster than the stock price or investors are paying less for the
stock for some reason. For example, they might be concerned about the
effect of government regulations on future earnings. Do your research
to determine why the P/E ratio has changed.

Figure 4-4. A company’s P/E ratio history in a spreadsheet

Column F in the Excel spreadsheet in Figure 4-4
calculates a company’s high P/E ratios for the last
ten years by dividing a year’s high price (column C)
by the company’s EPS (column E) for that year. For
example, Example 4-9 shows the Excel formula for
cell F61, the 1992 high P/E ratio.

Example 4-9. Excel function for calculating a high P/E ratio

High P/E Ratio (cell F61) = IF(E61<=0,"n/a",C61/E61)

The formula uses a conditional clause to ignore the calculation when
the company has zero or negative EPS figures. When a company has no
earnings or loses money, the resulting P/E ratio is meaningless and
doesn’t offer any help in valuing the company. The
low P/E ratios in column G are calculated in the same way.

Column H uses the annual high and low P/E ratios to determine an
average annual P/E ratio, as shown in Example 4-10.

Example 4-10. Excel function for calculating an average P/E ratio

=IF(E61<=0,"n/a",AVERAGE(F61:G61))

You can calculate average high and low P/E ratios for multiple years
to spot longer-term trends, too. The spreadsheet in Figure 4-4 contains five- and ten-year averages. The
ten-year average uses the function in Example 4-11.

You can quickly scan the columns to identify trends in a
stock’s P/E ratios: are they stable, increasing, or
declining? Investigate the causes of any changes. For example, is
tough competition cutting into the company’s profit
margins and resulting in lower earnings growth? Although lower
earnings increase the P/E ratio if the price stays the same,
you’ll rarely find the price unchanged for long when
earnings growth slows or declines.

You can compare the current P/E ratio to the historical trends and
averages [Hack #36], and gain a
better sense of whether the stock is over- or undervalued at its
current price. For example, when the current P/E ratio is higher than
the average as shown in Figure 4-4,
you’re paying a premium for the stock. You must be
particularly careful when P/E ratios trend down.
That’s often a sign that the price is dropping, and
you don’t want to buy as the price continues to
fall.

Dividend and Yield

The true measure of a
publicly traded
company’s success will always be the profits it
earns through the years. By reinvesting these profits back into its
business, a company funds further expansion without the need to
borrow money or sell additional shares to the public. For mature
companies, however, there can come a time when management simply
can’t find enough uses for all of the money it earns
each year. A company might then decide to start paying out a portion
of these profits to investors as dividends.

A regular stream of dividend payments is important to investors who
depend on their portfolios to deliver current income on which they
can live. That’s why stocks that pay high
dividends are sometimes known as
income stocks. For other investors, a dividend
contributes to the overall return they receive from their investment
and adds some security to the investment as well.

Analyzing the dividends that are paid by two different companies
isn’t as easy as figuring out how much each will pay
to investors in a year. You need the market value of each stock to
determine the dividend yield. The dividend yield
is useful when comparing two or more stocks, but you can also use it
to compare an investment to what you might earn in interest in a bank
account or to the yield on a bond. Example 4-12 shows
the formula for the yield represented by dividends paid.

A stock’s yield is usually
calculated using its
indicated dividend, the total that would be paid
per share over the next 12 months if each dividend were the same as
the most recent dividend.

Tip

A stock’s dividend yield does not include the return
you receive from the increase in stock price. Comparing dividend
yield to bond or bank account yields makes the most sense for
high-dividend stocks whose prices tend to be stable.

The Payout Ratio

Since dividends are, by definition, a
portion of a
company’s profits that are paid to its shareholders,
what happens to the dividend when a company earns fewer profits or
even begins to lose money? Eventually, the company will have to stop
paying dividends—a decision that is not popular with investors
who might be counting on those regular cash payments. On the other
hand, a company might pay too much of its income as dividends,
leaving it with inadequate working capital to expand its business,
pay down debt, or invest in other ways that might greatly benefit the
company.

One way to examine a company’s dividend policy is to
calculate its payout ratio. The payout ratio is
the amount of the company’s annual earnings that is
paid out as dividends to its investors. You can calculate it with the
formula in Example 4-13.

Example 4-13. Formula for the payout ratio

% Payout Ratio = ($ Annual Dividend / $ Annual EPS) x 100

Most companies are quite concerned with protecting their dividends,
because canceling or reducing dividend payments is never well
received by shareholders. In addition, shareholders often pressure
companies to increase their dividends on a regular basis. Many
companies take pride in the number of years that they have regularly
paid dividends to shareholders, as well as how often they have been
able to increase those payments. Investors tend to interpret this
historical record as a sign that a company is stable and safe.

The payout ratio can help you understand just how safe a
company’s dividend might be. High payout ratios are
double-edged swords. For investors seeking current income, a
consistently high payout ratio means more money to live on. In
addition, a long history of paying steadily increasing dividends is
often a sign of quality management and dependable performance.
However, a company with a high payout ratio doesn’t
retain much of its earnings to grow its business, so the dividend
might represent most, if not all, of the return you earn. Therefore,
for younger investors who want to grow their portfolios, a high
payout ratio might not be beneficial. High payout ratios can also
lead to financial problems, if the company doesn’t
retain enough of its earnings to operate effectively.

High payout ratios are fine in industries that don’t
require a lot of additional capital. However, companies like Intel,
which spends billions of dollars to build just one new plant, or
Pfizer, which spends over $5 billion a year in research and
development, require plenty of money to grow their businesses, and
paying out a lot of dividends is detrimental.

Tip

Because different industries have different capital requirements,
it’s a good idea to compare the payout ratio of a
company to the industry average. If a company payout ratio is below
average, investigate further to see if that is an indication of
problems or that the company has investment plans. For high payout
ratios, check financial strength ratios very carefully to make sure
the company can afford to pay out that much of its earnings.

Dividend payout ratios can increase when company earnings fall. If
you see the payout ratio increasing from year to year as earnings
decrease, don’t be surprised if the company slashes
its dividends. If the payout ratio is over 100 percent, annual net
income isn’t enough to cover the total cost of
dividends in that year. In that situation, companies must come up
with the cash in some other way, such as borrowing from the bank or
tapping into their own reserves. A company might do this to maintain
its dividend payment record during a short dry spell, but over time,
of course, a company simply can’t continue to pay
dividends if the cost exceeds what it earns in a year.

The Excel spreadsheet in Figure 4-5 continues the
price and dividend ratio study by calculating the payout ratio and
yield. To calculate the payout ratio, use the following formula in
cell J61:

=IF(E61<=0,"n/a",I61/E61)

The IF clause makes sure that the EPS are
positive. If a company is losing money, its dividends might be
reduced down the road. You should do more homework to evaluate the
cause and scope of the company’s problems.

Figure 4-5. Calculate yield and payout ratios in a spreadsheet

If you examine the company’s annual payout ratio
over several years, you can spot negative trends, such as increasing
payout ratios from decreasing earnings that could forebode a coming
crisis in the company’s operations. You can also
calculate an average payout ratio over five years to estimate how
much a company might pay in dividends in the future.

Going Beyond the P/E Ratio

Because there are several flavors of earnings per share [Hack #15] (such as excluding
extraordinary items, as reported, and normalized), make sure you know
what kind of EPS figures are used to calculate a P/E ratio,
particularly when comparing several companies.

The P/E ratio is calculated using earnings from the last four
reported quarters. These trailingearnings are
indicated with TTM,
which stands for trailing twelve months. Some
data providers calculate P/E ratios using EPS from the last two
reported quarters plus the projections for the next two quarters. The
projected P/E ratiouses
estimated EPS for the next four quarters. The projected P/E ratio is
helpful when you evaluate companies with very high EPS growth rates,
because current P/E ratios for fast-growing companies are almost
always high. The projected P/E ratio compares the current price,
which typically incorporates expectations of future earnings, with
those future earnings.

After you’ve determined the annual P/E ratio for the
last five or ten years, you can refine your analysis with
one additional calculation.
Relative value (RV) is the ratio of what
investors are paying today for a stock compared to what they have
paid on average in the past. Relative value is
calculated with the formula in Example 4-14.

Example 4-14. Formula for relative value

% Relative Value = (Current P/E Ratio / Average P/E Ratio) * 100

Relative value is expressed as a percentage. Generally, a stock with
a relative value less than 100 percent is undervalued; if RV is much
greater than 100 percent, a stock is probably overvalued. Most
long-term investors consider a relative value between 90 percent and
110 percent as an indication of fair value. If RV is much less than
70 percent, the company might be going through a tough patch, and
investors have bid down the share price because of their reduced
expectations. In this case, the very low RV is a signal of trouble,
not of a bargain price. However, by 2002 and 2003, many good
companies carried RVs below 70 percent, because investors were being
careful on account of the ongoing bear market.

Conversely, when RV is above 150 percent, investors are paying a
significant premium for a stock. This can indicate that the stock has
reached a price peak, and the only direction it can go from there is
down. For companies with below-average growth rates, selling might be
in order. However, for higher-growth companies, an RV of 150 is quite
common.

One last wrinkle: you can also calculate projected relative value by
substituting the projected P/E ratio for the current P/E in the
relative value calculation in Example 4-14. This can
be useful in comparing several stocks when analysts and investors see
weakness in the next year for a particular company or industry.

Viewing Price and Dividend Ratios and Trends

With P/E ratios and dividend ratios, the more you compare, the better you can
evaluate the current value of stock price. Comparing the current P/E
ratio to historical values, P/E ratios of other companies, or average
P/E ratios for the industry can indicate whether a stock is
overpriced. Comparing dividend yields and payout ratios to those of
other companies or the industry average can help you determine
whether the ratios are signs of safety or trouble. You can compare
ratios and view historical trends on several web sites. Each one has
its own benefits, so you might choose to use one or all in your stock
studies.

Historical price and dividend charts

With BigCharts (http://bigcharts.marketwatch.com), you can
create
charts that show historical prices, P/E ratios, dividends, and
yields, as shown in Figure 4-6. For example, Home
Depot’s P/E ratio has cycled from values below 20 to
as high as 75 twice in the past 25 years.

Figure 4-6. Using BigChart’s interactive charting, you can see the historical variation in Home Depot’s P/E ratio

Type a ticker symbol in the Symbol box at the top of the page and
click Interactive Charting.

In the Time drop-down list, choose All Data.

In the Frequency drop-down list, choose Monthly.

Click the Indicators button.

In the Lower Indicators boxes, choose one of the following measures:

P/E Ratio

Displays the P/E ratio calculated using the rolling 52-week EPS

P/E Ranges

Shows high and low P/E ratios for the period you choose in the
Frequency list

Rolling Dividends

Displays the rolling 52-week dividend as dollars per share

Yield

Shows yield calculated by dividing the 52-week rolling dividend by
the stock closing price and multiplying by 100

Click the Draw Chart button.

Comparing historical price ratios

At Morningstar (http://www.morningstar.com), you can compare
current
and ten years of historical P/E
ratios as well as three other stock valuation ratios: price/book,
price/sales, and price/cash flow. The table also includes the
valuation ratios for the S&P 500 index. Type a ticker symbol in
the Ticker box on the Morningstar home page and then select the
Valuation Ratios tab on the stock page. To see ten years of ratios,
select the 10-Yr Valuation tab above the table. Select the Yields tab
to see a graph of the earnings and dividend yield for the stock
compared to other yields, such as the 30-year T-bond yield.

Comparing ratios to the competition

Quicken.com (http://www.quicken.com) provides an easy way
to
compare
all sorts of financial measures and ratios to the competition.

On the Quicken.com home page, type
a ticker symbol in the Enter Symbol box
and click Go.

On the stock page, click Compare to Industry. You can check the
checkboxes for the competitors you want to evaluate or type
additional ticker symbols (separated by commas) in the
“Enter tickers of the companies you want to
compare” box. The table of competitors includes the
market capitalization for each company, so you can choose competitors
of similar size.

Tip

To add an index to the comparison, find its ticker symbol by clicking
the “Don’t know the
symbol” link. Select the Index option, type
Index in the Name box, and then click Search.
You can cut one of the symbols from the Quicken Ticker Search window
and paste it in the box on the “Compare to
industries” page.

Under the Choose Information to Display heading, select the
Fundamentals option. Click Compare. For each category of measures,
Quicken.com displays a row for each company and index you chose with
several measures in each row.

—Douglas Gerlach

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